1113fust.pdfthe rising gap between primary and secondary mortgage rates

8/14/2019 1113fust.pdfThe Rising Gap between Primary and Secondary Mortgage Rates

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1. I

he vast majority o mortgage loans in the United Statesare securitized in the orm o agency mortgage-backed securities (MBS). Principal and interest payments

on these securities are passed through to investors and

are guaranteed by the government-sponsored enterprises

(GSEs) Fannie Mae or Freddie Mac or by the government

organization Ginnie Mae.1Tus, investors in these securities

are not subject to loan-specific credit risk; they ace only

interest rate and prepayment riskthe risk that borrowers

may refinance the loan when rates are low.2

In the primary mortgage market, lenders make loans to

borrowers at a certain interest rate, whereas in the secondary

market, lenders securitize these loans into MBS and sell them

to investors. When thinking about the relationship between

these two markets, policymakers and market commentators

usually pay close attention to the primary-secondary spread.

Tis spread is calculated as the difference between an average

1 Fannie Mae is the Federal National Mortgage Association (or FNMA);

Freddie Mac is the Federal Home Loan Mortgage Corporation (FHLMC;

also FGLMC); Ginnie Mae is the Government National Mortgage

Association (GNMA).

2 Tey also ace the risk that borrowers prepay at lower-than-expected speeds

when interest rates rise.

While the primary-secondary mortgagerate spread is a closely tracked series, it isan imperfect measure of the pass-throughbetween secondary-market valuations andprimary-market borrowing costs.

This study tracks cash ows during and afterthe mortgage origination and securitizationprocess to determine how many dollars(per $100 loan) are absorbed by originators,either to cover costs or as originator prots.

The authors calculate a series of originatorprots and unmeasured costs (OPUCs) forthe period 1994-2012, and show that theseOPUCs increased signicantly between2008 and 2012.

Although some mortgage origination costsmay have risen, a large component of therise in OPUCs remains unexplained bycost increases alone, pointing to increasedprotability of originators.

FRBNY E P R / F

Andreas Fuster, Laurie Goodman, David Lucca, Laurel Madar, Linsey Molloy,and Paul Willen

R G P SM R

Andreas Fuster and David Lucca are senior economists in the Federal Reserve

Bank o New Yorks Research and Statistics Group; Laurie Goodman is the

center director o the Housing Finance Policy Center at the Urban Institute;

Laurel Madar and Linsey Molloy are associates in the Banks Markets Group;

Paul Willen is a senior economist and policy advisor in the Federal Reserve

Bank o Bostons Research Department.

Corresponding authors: [email protected]; [email protected]

Tis article is a revised version o a white paper originally prepared as back-

ground material or the workshop Te Spread between Primary and Secondary

Mortgage Rates: Recent rends and Prospects, held at the Federal Reserve

Bank o New York on December 3, 2012. Te authors thank Adam Ashcraf,

Alan Boyce, James Egelho, David Finkelstein, Kenneth Garbade, Brian Landy,

Jamie McAndrews, Joseph racy, and Nate Wuerffel or helpul comments,

and Shumin Li or help with the data. Te views expressed are those o the

authors and do not necessarily reflect the position o the Federal Reserve Bank o

New York, the Federal Reserve Bank o Boston, or the Federal Reserve System.


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mortgage interest rate (usually coming rom the Freddie Mac

Primary Mortgage Market Survey) and a representative yield

on newly issued agency MBSthe current-coupon rate.

Chart 1 shows a time series o the primary-secondary

spread through the end o 2012. Te spread was relatively

stable rom 1995 to 2000, at about 30 basis points; it

subsequently widened to about 50 basis points through early

2008, but then reached more than 100 basis points in early

2009 and during 2012. Following the September 2012 Federal

Open Market Committee announcement o additional MBS

purchases, the spread temporarily rose to more than 150 basispointsa historical high that attracted much attention rom

policymakers and commentators at the time.

While the primary-secondary spread is a closely watched

series, it is an imperect proxy or the degree to which secondary-

market movements are reflected in mortgage borrowing costs

(the pass-through) since, among other things, the secondary

yield is not directly observed, but model-determined, and thus

subject to model misspecification. Furthermore, mortgage

market pass-through depends on the evolution o the GSEs

guarantee ees (or g-ees, the price the GSEs charge or insuring

the loan) as well as on mortgage originators margins. o

understand changes in the extent o pass-through over time, itis useul to track the two components separately. While g-ee

changes are easily observable, we argue that originator margins

are best studied by tracking the different cash flows during

and afer the origination process, rather than by looking at the

primary-secondary spread (even afer netting out g-ees). Indeed,

since originators are selling the loans, their margin depends on

the price at which they can sell them, rather than the interest rate

on the security into which they sell the loans.

o get a sense o what lenders earn rom selling loans, we

first consider a simple back-o-the-envelope calculation.

We track the secondary-market value o the typical offered

mortgage loan (according to the Freddie Mac survey) over

time, assuming that the lender securitizes and sells the loan

as an agency MBS. o do so, we first deduct the g-ee romthe loans interest stream. We then compute the value o

the remaining interest stream by interpolating MBS prices

across coupons and subtracting the loan amount o $100.3

Chart 2 shows that the approximate net market value o a

mortgage grew rom less than 100 basis points (or $1 per

$100 loan) beore 2009 to more than 350 basis points in

the second hal o 2012. aken literally, the chart implies

that lender costs (other than the g-ee), lender profits, or a

combination o the two must have increased by 300 basis

points, or a actor o our, in five years.

In this article, we first present a more detailed calculation

o originator profits and costs, and then attempt to explain

their rise by considering a number o possible actors

3 For instance, assume that the mortgage note rate is 3.75 percent and

the g-ee is 50 basis points, such that the remaining interest stream

is 3.25 percent. Assuming that the 3.0 percent MBS trades at 102 and

the 3.5 percent MBS trades at 104.5, the approximate market value o

this mortgage in an MBS pool would then be simply the average o the

two prices, 103.25, or 3.25 net o the loan principal.

Chart 1

The Primary-Secondary Spread

Basis points

Sources: Bloomberg L.P.; Freddie Mac.

0

25

50

75

100

125

150

175

1210080604020098961995

Eight-weekrolling window

Weekly

0

1

2

3

4

5

1211100908072006

C

Back-of-the-Envelope Calculation of theNet Market Value of a Thirty-Year Fixed-RateMortgage Securitized in an Agency MBS

Sources: JPMorgan Chase; Freddie Mac; Fannie Mae; authorscalculations.

Notes: e chart shows the interpolated value of a mortgage-backedsecurity (MBS) with coupon (rprimary g-fee) minus 100. e linereflects an eight-week rolling window average; the calculation usesback-month MBS prices.

Dollars per $100 loan


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affecting them. In section 2, we begin with a general

discussion o the mortgage origination and securitization

process, and how originator profits are determined.

Here, we include a detailed discussion o the valuation o

revenues rom servicing and points as well as costs rom

g-ees, based on standard industry methods. Next, in

section 3 we use these methods to derive a time series o

average originator profits and unmeasured costs (OPUCs)or the period 1994-2012, which largely reflects the time-

series pattern o Chart 2. We then compare OPUCs and

the primary-secondary spread as measures o mortgage

market pass-through. Finally, in section 4 we turn to

possible explanations or the increase in OPUCs, including

putback risk, changes in the valuation o mortgage servicing

rights, pipeline hedging costs, capacity constraints, market

concentration, and streamline refinancing programs. While

some o the costs aced by originators may have risen over

the period 2008-12, we conclude that a large component o

the rise in OPUCs remains unexplained by cost increases

alone, suggesting that originators profits likely increased

over this period. We then discuss possible sources o the

rise in profitability. Capacity constraints likely played a

significant role in enabling originator profits, especially

during the early stages o refinancing waves. Pricing power

coming rom refinancing borrowers switching costs could

have been another actor sustaining originator profits.4

2. M P

M O

2.1 Te Origination and SecuritizationProcess

Te mortgage origination process begins when a borrower

seeks a quote or a loan, either to purchase a home or to

refinance an existing mortgage. Based on the borrowers

credit score, stated income, loan amount, and expected

loan-to-value (LV) ratio, an originator offers the borrowera combination o an interest rate and an estimate o the

amount o money the borrower will need to provide up ront

4 Importantly, this article ocuses on longer-term changes in the level o

originator profits and costs, rather than on the high-requency pass-through

o changes in MBS valuations to the primary mortgage market.

to close the loan.5For example, or a borrower who wants

a $300,000, thirty-year fixed-rate mortgage, the originator

may offer a 3.75 interest rate, known as the note rate, with

the borrower paying $3,000 (or 1.0 percent) in closing costs.

I the borrower and originator agree on the terms, then the

originator will typically guarantee these terms or a lock-in

period o between thirty and ninety days, and the borrower

will officially apply or the loan.During the lock-in period, the originator processes the

loan application, perorming such steps as veriying the

borrowers income and the home appraisal. Based on the

results o this process, borrowers may ultimately not qualiy

or the loan, or or the rate that the originator initially

offered. In addition, borrowers have the option to turn

down the loan offer, or example, because another originator

may have offered better loan terms. As a result, many loan

applications do not result in closed loans. Tese all-outs

fluctuate over time and present a risk or originators, as we

discuss in more detail in section 4.

Originators have a variety o alternatives to und loans:

they can securitize them in the private-label MBS market or

in an agency MBS, sell them as whole loans, or keep them on

their balance sheets. In the ollowing discussion, we ocus on

loans that are conorming (meaning that they ulfill criteria

based on loan amount and credit quality, so that they are eligi-

ble or securitization by the GSEs), and assume securitization

in an agency MBS, meaning that this option either dominates

or is equally profitable to the originators alternatives.6,7

5 Troughout this article, we use the terms lender or originator somewhat

imprecisely, as they lump together different origination channels that in

practice operate quite differently. Currently, the most popular origination

channel is the retail channel (or example, large commercial banks that lend

directly), which accounts or about 60 percent o loan originations, up rom

around 40 percent over the period 2000-06 (source: Inside Mortgage Finance).

Te alternative wholesale channel consists o brokers and correspondent

lenders. Brokers have relationships with different lenders that und their

loans, and account or about 10 percent o originations. Correspondent

lenders account or 30 percent o originations, and are typically small

independent mortgage banks that have credit lines rom and sell loans

(usually including servicing rights) to larger aggregator or sponsor banks.

Our discussion in this section applies most directly to retail loans.

6 Te raction o mortgages that are not securitized into agency MBS has

steadily decreased in recent years, according to Inside Mortgage Finance:

while the estimated securitization rate or conorming loans ranged

rom 74 to 82 percent over the period 2003-06, it has varied between87 and 98 percent since then (the 2011 value was 93 percent). Te private-

label MBS market has effectively been shut down since mid-2007, with the

exception o a ew deals involving loans with amounts exceeding the agency

conorming loan limits (jumbo loans).

7 Our discussion throughout this article applies directly to conventional

mortgages securitized by the GSEs Fannie Mae and Freddie Mac; the process

o originating Federal Housing Administration (FHA) loans and securitizing

them through Ginnie Mae is similar, but with some differences (such as

insurance premia) that we do not cover here.


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A key eature o an agency MBS is that principal and interest

payments or these securities are guaranteed by the GSEs.8Te

GSEs charge a monthly flow payment, the g-ee, which is a fixed

raction o the loan balance. Flow g-ees do not depend on loan

characteristics but may differ across loan originators. Until 2012,

flow g-ees averaged approximately 20 basis points per year,

but during 2012 they rose to about 40 basis points, reflecting a

Congressionally mandated 10-basis-point increase to und the2012 payroll tax reduction and another 10-basis-point increase

mandated by the Federal Housing Finance Agency (FHFA). As

we discuss below, originators can convert all or part o the flow

g-eeinto an up-ront premium by buying down the g-ee.

Alternatively, they can increase the flow g-ee and receive an up-

ront transer rom the GSE by buying up the g-ee.

Since 2007, the GSEs have also been charging a separate

up-ront premium due upon delivery o the loan, known as

the loan-level price adjustment (LLPA).9Te LLPA contains a

fixed charge or all loans (currently 25 basis points) known as

an adverse-market delivery charge, as well as additional loan-

specific charges that depend on loan characteristics such as

the term o the loan, the LV, and the borrowers FICO score.

For instance, as o early 2013, the LLPA or a borrower with a

FICO score o 730 and an LV o 80 was 50 basis points (or a

thirty-year fixed-rate loan; the charge is waived or loans with

a term o fifeen or ewer years). ogether with the 25-basis-

point adverse-market delivery charge, this implies that the loan

originator pays an up-ront ee equal to 0.75 percent o the loan

amount. Tus, the total up-ront transer between the originator

and GSE consists o the LLPA plus or minus potential g-ee

buy-ups or buy-downs, which can be either positive or negative.

For simplicity, our discussion assumes that the transer rom theoriginator to the GSE is positive and reers to it as an up-ront

insurance premium (UIP).

Once an originator chooses to securitize the loan in an

agency MBS pool, it can select rom different coupon rates,

which typically vary by 50-basis-point increments. Te note rate

on the mortgage, or example, 3.75 percent, is always higher than

the coupon rate on an agency MBS, or example, 3.0 percent.

Who receives the residual 75-basis-point interest flow?

Assuming the originator does not buy up or down the g-ee,

approximately 40 basis points go to the GSEs (as o early 2013),

leaving 35 basis points o servicing income. Te GSEs require

the servicer to collect at least 25 basis points in servicing income,known as base servicing. Base servicing is tied to the right

8 I the loan is ound to violate the representations and warranties made by the

seller to the GSEs, the GSEs may put the loan back to the seller.

9 LLPA is the official term used by Fannie Mae; Freddie Mac calls the

corresponding premium postsettlement delivery ee. Te respective ee grids

can be ound at www.anniemae.com/content/pricing/llpa-matrix.pd and

www.reddiemac.com/singleamily/pd/ex19.pd.

and obligation to service the loan (which involves, or instance,

collecting payments rom the borrower) and can be seized by the

guaranteeing GSE i the servicer becomes insolvent. Servicing

income in excess o 25 basis points10 basis points in this

exampleis known as excess servicing, and is a pure interest

flow. One might surmise here that a loan in a 3.0 percent pool

must have a rate o 3.65 percent or higher (3.0 plus 40 basis

points or the g-ee plus 25 basis points or base servicing),

but recall rom above that the originator can buy down the

g-ee so, in act, the minimum note rate in a 3.0 percent pool

is 3.25 percent. In practice, or a mortgage o a given note rate,

originators compare the profitability o pooling it in different

coupons, as described below.

Originators typically sell agency loans in the so-called BA

(to-be-announced) market. Te BA market is a orward market

in which investors trade promises to deliver agency MBS at

fixed dates one, two, or three calendar months in the uture. For

concreteness, Exhibit 1 displays BA prices rom Bloomberg at

11:45 a.m. on January 30, 2013. At this time, investors will pay

102 14+/32102.45 or a 3.0 percent Fannie Mae (here denoted

FNCL) MBS or April settlement. o understand the role o the

BA market, suppose that Bank A expects to have $100 million

o 3.5 percent note rate mortgages available or delivery in

April. In order to hedge its interest rate risk, Bank A will then

sell $100 million par o 3.0 percent pools orward in the BA

market at a price o $102.45 per $100 par, to be delivered on

the standard settlement day in April. Over the ollowing weeks,

E 1

Example of a TBA Price Screen

Source: Bloomberg L.P.

Notes: Prices are quoted in ticks, which represent 1/32ndof a dollar; for

instance, 103-01 means 103 plus 1/32 = $103.03125 per $100 par value.e + sign represents half a tick (or 1/64). Quotes to the le of the/ are bids, while those to the right are asks (or offers).


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Bank A assembles a pool o loans to be put in the security and

delivers the loans to Fannie Mae, which then exchanges the

loans or an MBS. Tis MBS is then delivered by Bank A on

the contractual settlement day to the investor who currently

owns the BA orward contract in exchange or the promised

$102.45 million. A key eature o a BA trade is that at the time o

trade, the seller does not speciy which pools o loans it will deliverto the buyerthis inormation is announced only shortly beore

the trade settles. As a consequence, market participants generally

price BA contracts under the assumption that sellers will deliver

the least valuableor cheapest-to-deliverpools at settlement.10

2.2 How Does an Originator Make Money onthe ransaction?

A mortgage loan involves an initial cash flow at origination

rom investors to the borrower, and subsequent cash flowsrom the borrower to investors as the borrower repays the

loan principal and interest.Exhibit 2 maps these cash flows or

a mortgage loan securitized in a Fannie Mae MBS and sold

in the BA market. Te top panel shows the origination cash

flow, which involves the investor paying price BA(rcoupon

) to

the originator in exchange or an MBS with coupon rate rcoupon

.

10 See Vickery and Wright (2013) or an overview o the BA market.

From the investors payment, an originator unds the loan and

pays any UIPto Fannie Mae.11ogether with points received

rom the borrower, the cash flow to the originator when the

loan is made equals:

___Origination cash flow (1)

=BA(rcoupon

)+points100UIP.

Trough the lie o the loan (middle panel o Exhibit 2),

a borrower pays the note rate, rnote

, rom which Fannie Mae

deducts theg-feeand the investor gets rcoupon

, leaving servicing

cash flow to the originator equal to:

t___servicing cash flow

t=r

noteg-feer

coupon. (2)

Originator profits per loan are the sum o profits at

origination (equation 1) and the present value (PV) o the

servicing cash flow (equation 2) less all marginal costs (other

than theg-fee) o originating and servicing the loan, which wecall unmeasured costs. Tus,

originator profits=+PV(1,

2,) (3)

unmeasured costs.

11 Here and below, originator reers to all actors in the origination and

servicing process, that is, i a loan is originated through a third-party

mortgage broker, or instance, the broker will earn part o the value.

E

Mortgage Loan Securitized in an Agency MBS and Sold in TBA Market: The Money Trail

Cash flowfrom investorto borrower

(at time oforigination)

Cash flowfrom borrower

to investor(during life of

loan; expressed inannual terms)

Net benefit

Receives $100 for loan

Payspointsto originator

for closing costs

100 -points- PV(rnote)

- PV(principal repayment)

Origination Cash Flow: =TBA(rcoupon) +

points 100 UIP

Servicing Cash Flow:t=

rnote-g-fee - rcoupon

OPUCs= + PV(1, ...)= TBA(rcoupon) - UIP

- 100 + points +PV(rnote- g-fee - rcoupon)

UIP + PV(g-fee)

Borrower OriginatorGovernment-Sponsored

Enterprise Investor

Receives UIP

Receivesg-fee

PV(rcoupon)+ PV(principal repayment)

- TBA (rcoupon)

Pays TBA (rcoupon) for loan

PaysrnotePaysprincipal repayment

ReceivesrcouponReceivesprincipal repayment

Note: TBA(rcoupon) is the price of a mortgage-backed security (MBS) with coupon rate rcouponin the to-be-announced market; UIPis up-front insurancepremium (consisting of loan-level price adjustments plus or minus potential g-fee buy-ups or buy-downs); PVis present value.


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In our empirical exercise below, we study the sum o profits

and unmeasured costs, which is what we can observe:

originator profits and (4)

unmeasured costs (OPUCs) =+PV(1,

2,).

In later sections o the article, we attempt to assess to what

extent changes in unmeasured costs can explain fluctuations

in OPUCs.

We next consider a specific transaction to illustrate how

the computations in Exhibit 2 are done in practice. Consider

a loan o size $100 with a note rate o 3.75 percent locked in

on January 30 or sixty days by a borrower with a FICO score

o 730 and an LV ratio o 80. Te borrower agrees to pay

1 point to the originator or the closing, and the originator

sells the loan into a BA security with a 3.0 percent coupon

or April settlement to allow sixty days or closing. Assuming

the loan closes, how high are the OPUCs?

Computing the net revenue at origination,, is relatively

straightorward. According to Exhibit 1, investors pay$102.45 or every $100 o principal in a BA security with

a 3.0 percent coupon. As discussed earlier, the up-rontinsurance premium rom the LLPA (and assuming no g-ee

buy-up/-down) at the time was 0.75 percent o the loan

(or 0.75 points). Te originator collects 1 point rom the

borrower, remitting $100 or the loan, yielding =2.7 points.

Valuing the stream o servicing income afer origination,

(1,

2, ), is more complicated. For now, we assume that the

originator does not buy up or down the g-eea decision that

we will revisit below. Tis means that rom the borrowers

interest flow o 3.75 percent, the GSEs collect 40 basis points,

while the investors get 3.0 percent, leaving 35 basis points in

flow servicing income, t, decomposed into 25 basis points o

base servicing and 10 basis points o excess servicing. Tereare a number o alternative ways to determine the present

value o these flow payments:

IO Strip Prices or Coupon Swaps

Servicing income can be thought o as an interest-only (IO)

strip, which is a security that pays a flow o interest payments,

but no principal payments, to investors as long as a loan is

active.12Te main driver o the valuation o an IO strip is

the duration o the loanan IO strip is ar more valuable i

one expects the borrower to prepay in five years as opposedto one year; as in the latter case, interest payments accrue

or a much shorter time period. One simple way to value

IO strips is to construct them rom BA securities through

coupon swaps. For example, going long on a 3.5 percent

MBS and short on a 3.0 percent MBS generates interest cash

flows o 50 basis points with prepayment properties that

correspond roughly to loans in 3.0 and 3.5 pools. According

to Exhibit 1, that 50-basis-point IO strip or April settlement

would cost 2 11/32 (104 25+/32 minus 102 14+/32) 2.34.

Since our originator has only 35 basis points o servicing,

the coupon swap method would value servicing

rights at 35/502.341.6, resulting in OPUCs o2.7 +1.6=4.3 points.13

Tis method ignores the act that base servicing

generates other revenues, such as float income, in addition

to the IO strip. o account or this additional value, it

is ofen assumed that the base servicing is worth more

than the present value o the IO strip. Assuming that base

servicing is worth, or example, 25 percent more than

excess servicing would yield a PV o servicing income o

(25 1.25 +10)/502.341.9, so that OPUCs would equal

2.7 +1.9=4.6 points.

Another shortcoming o the coupon swap method is that the

coupon swap reflects differences in assumed loan characteristicsacross coupons. For example, BA prices may reflect the

act that higher coupons are older securities having different

prepayment characteristics. Tese differences will distort the

valuations o interest streams rom the coupon swaps.14

Constant Servicing Multiples

An alternative method or valuing servicing flows is to use

fixed accounting multiples that reflect historical valuations o

12 Another way to describe an IO strip is as an annuity with duration equal to

the lie o the loan.

13 Tis is the method implicitly used in the back-o-the-envelope calculation

in Chart 2, except that there we ignored points paid by the borrower.

14 As an illustration, a 50-basis-point IO strip rom a new 4.0 percent loan

may not be worth as much as the price difference between the 3.5 and the

4.0 BAs suggests, because the 4.0 BAs may consist o loans that are older

or credit impaired and thus prepay more slowly.

Computing the net revenue at

origination, , is relatively

straightforward. Valuing the stream

of servicing income after origination,

(1,

2, ), is more complicated.


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servicing. In the industry, the base servicing multiple is ofen

assumed to be 5x, meaning that the present value o 25 basis

points equals 1.25, while excess servicing is assumed to be

valued at 4x, so that the value o the excess servicing in our

example is 0.40. Using these servicing multiples, we see that

the servicing income in our example is worth 1.65, meaning

that OPUCs or this loan would be 2.7 +1.65 =4.35 points.

Buy-ups

As mentioned above, originators can convert the g-ee into an

up-ront premium, or vice versa, using buy-ups and buy-downs.

A buy-up means that the flow g-ee increases, but to compensate,

the GSE will reduce the UIP (or, in case it is negative, transer

money to the originator upon delivery o the loan). Tus, buying

up the g-ee is a way to reduce the flow servicing income and

increase income at the time o origination.

Te GSEs offer a buy-up multiple, which is communicated

to originators (but not otherwise publicly known), and varies

over time, presumably with the level o the coupon swap. I,

or example, the buy-up multiple is 3x, then a 10-basis-point

increase in the g-ee reduces UIP by 30 basis points, lowering

tby 0.1 and raising by 0.3. Note that only excess servicing,

t, -0.25, can be monetized this way, while 25 basis points

o base servicing still need to be retained and valued by the

originator. I we assume a base servicing multiple o 5x, as

above, then buying up the g-ee by 10 basis points would lead

to OPUCs o 3.0 +1.25 =4.25.

Te buy-up multiple provides a lower bound on the

valuation o excess servicingthe originator (or some otherservicer) may value it at a higher multiple; but i it does not,

it can sell its excess servicing to the GSEs. o what extent

originators want to take advantage o this option depends on

a number o actors. For example, as we discuss in section 4.1,

the upcoming implementation o Basel III rules may require

banks to hold additional capital against mortgage servicing

assets, which may lower their effective valuation o servicing

income. By buying up the g-ee, these banks can turn servicing

cash flows that are subject to additional regulatory capital

charges into cash. Another potential actor is the originators

belies about the prepayment properties o a pool o loans. For

example, i a lender believes that the expected lietime o a poolis shorter than average, it may choose to buy up the g-ee.

Market Prices of Servicing Rights

Finally, there is an active market or trading servicing rights,

which can be sold by originators at origination or well afer-

ward. One can use market prices to value servicing rights, but

since not all servicing rights change hands, it is difficult to

know whether the ones that trade are systematically more or

less valuable than the ones that originators hold.

2.3 Best Execution

Lenders can decide to securitize a loan into securities havingdifferent coupons, which involves different origination and

servicing cash flows. Te strategy that maximizes OPUCs is

known in the industry as best (or optimal) execution.15

Tus ar, we have assumed that the originator securitizes

the loan in a 3.0 coupon. However, since the note rate is 3.75,

the originator could alternatively sell it in a 3.5 coupon.16

Given that the originator must retain 25-basis-point base

servicing, such a choice would require buying down the

entire 40-basis-point g-ee, meaning that instead o any flow

payment to the GSE, the originator pays the ull insurance

premium up ront. Exactly like the buy-up multiple discussed

above, the GSEs also offer a (higher) buy-down multiple,which determines the cost o this up-ront payment.

Using the prices in Exhibit 1, we note that the price

o a 3.5 BA coupon is 104 24+/32=104.77, meaning

that changing coupons would increase loan sale revenues

by 2.32 points. I we assume the buy-down multiple

equals 7, then UIP would increase by 2.8 points relative to

the 3.0 coupon case. is thus equal to 2.22, or 0.48 less than

it would be or the 3.0 coupon case. Meanwhile, servicing

income is now simply t=0.25, as the flow g-ee has been

bought down to zero, and with an assumed base servicing

multiple o 5x, OPUCs or this execution would equal

2.22+1.25=3.47.

Comparing this OPUC value with the constant

servicing multiples case above, we see that pooling into

the 3.0 coupon would generate higher OPUCs than the

3.5 coupon and thus would be best execution or a mortgage

with the 3.75 percent note rate.

However, this conclusion is sensitive to a number o

assumptionsin particular, the valuation o excess servicing

and the buy-down multiple.17As shown in able 1, pooling in

the higher coupon becomes more attractive as the buy-down

multiple decreases or the excess servicing multiple decreases.

15 See Bhattacharya, Berliner, and Fabozzi (2008) or an extensive discussion

o pooling economics and mortgage pricing that also includes nonagency

securitizations.

16 Te originator could also place the loan in a 2.5 percent or lower coupon

the only restriction is that the note rate cannot be more than 250 basis points

above the coupon.

17 As base servicing always needs to be retained, its valuation does not affect

best executionit shifs OPUCs up or down equally or all coupons.


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T R G

2.4 Rate Sheets and Borrower Choice

Until now, we have taken the borrower choice as giventhe

borrower pays 1 point at origination and is offered a note rate o

3.75. However, rom our OPUC calculations, it is clear that thereare other combinations o note rate and points that would be

equally profitable or the originator. For example, i the borrower

paid a note rate o 4.0 instead, and the originator still pooled

the loan into a 3.0 coupon, then excess servicing would increase

by 25 basis points, leading to 1 point higher revenue under

an excess servicing multiple o 4x. Tereore, the originator

could maintain its profit margin by offering the borrower a

combination o 0 points at closing and a note rate o 4.0.18

Indeed, originators offer borrowers precisely these sorts

o alternatives between closing costs and rates. able 2 shows

part o a rate sheet provided by a bank to a loan officer on

January 30, 2013.19Te entries in the table are discountpoints, which are points paid by the borrower at closing to

lower the note rate on the loan. For example, assume that the

total closing ees the originator would charge the borrower

without any discount points would equal 1.58 points

sometimes reerred to as origination points. Tese ees

include application processing costs, compensation or the

loan officer, and also the LLPA (0.75 points in our example),

which is usually charged directly to the borrower.

Our baseline borrower has a sixty-day lock-in period and

a note rate o 3.75 percent; accordingly, based on the rate

sheet, the borrower is contributing -0.581 discount points.

Tis means that the bank is actually paying the borrower

cash up ront (ofen reerred to as a rebate), which reduces

closing costs rom 1.58 points to the 1 point assumed

18 In act, the 4.0 note rate might increase the profit margin, because it would

potentially alter the best-execution coupon.

19 Actual sample rate sheets can be ound, or instance, at www.53.com/

wholesale-mortgage/wholesale-rate-sheets.html. Most lenders do not make

their rate sheets available to the public.

throughout the example. I the borrower wanted a lower note

rate, or example, 3.5 percent, then the closing costs would

rise by 1.044 (-0.581) =1.625, or rom 1 to 2.625 points.Alternatively, by choosing a rate o 4.125 percent, the

borrower could get a rebate o 1.581 points and would pay

nothing at closing.

As shown in the rate sheet, there is no single mortgage

rate. Rather, a large number o different note rates are

available to borrowers on any given day, typically in

increments o 0.125.20Originators simply change the number

o discount points offered or the different note rates one or

more times a day, reflecting secondary-market valuations

(BA prices), servicing valuations, and GSE buy-up/

buy-down multiples.21

20 Tat said, banks will ofen quote a headline mortgage rate, which is

generally the lowest rate such that the number o discount points required

rom the borrower is reasonable (this rate is sometimes reerred to as

the best-execution rate or the borrower, not to be conused with the

originators best execution). In the example rate sheet, this rate would likely be

3.75 or 3.625, as going below 3.625 requires significant additional points rom

the borrower.

21 Te set o available note rates on a given day generally depends on which

MBS coupons are actively traded in the secondary market.

Example of a Mortgage Rate Sheet

Lock-in Period

Note Rate Fifeen Days Tirty Days Sixty Days

4.750 (3.956) (3.831) (3.706)

4.625 (3.831) (3.706) (3.581)4.500 (3.706) (3.581) (3.456)

4.375 (3.331) (3.206) (3.081)

4.250 (3.081) (2.956) (2.831)

4.125 (1.831) (1.706) (1.581)

4.000 (1.456) (1.331) (1.206)

3.875 (1.081) (0.956) (0.831)

3.750 (0.831) (0.706) (0.581)

3.625 (0.081) 0.044 0.169

3.500 0.794 0.919 1.044

3.375 1.669 1.794 1.919

3.250 2.544 2.669 2.794

3.125 3.919 4.044 4.169

Source: www.53.com/wholesale-mortgage/wholesale-rate-sheets.html on

January 30, 2013.

Notes: Figures are in percentage points o the loan amount. Loan type is a

thirty-year fixed-rate loan. Column 1 shows the annual interest rate to be

paid by the borrower over the lie o the loan. Columns 2-4 show the points

the borrower needs to pay up ront to obtain the interest rate in column 1,

or different lock-in periods. Parentheses denote negative figures.

Dependence of Best Execution on Excess Servicingand Buy-Down Multiples

Excess Servicing Buy-Down OPUCs(3.0) OPUCs(3.5)

Multiple Multiple (Points)

4x 7x 4.35 3.47

4x 5x 4.35 4.27

3x 5x 4.25 4.27

Sources: Bloomberg L.P.; authors calculations.

Note: OPUCs are originator profits and unmeasured costs.


9/23

FRBNY E P R / F

2.5 Summary: rade-offs, rade-offsEverywhere

As shown in the preceding discussion, the different actors in

the origination and securitization process have a number o

trade-offs available to them. Borrowers can decide between

paying more points up ront and paying a higher interest rate

later. Originators can choose between different coupons into

which to pool a loan, which imply different origination and

servicing cash flows; in addition, as part o this decision, origi-

nators can choose whether to pay the GSE insurance premium

up ront or as a flow. Finally, investors can choose to invest

in securities with different coupons, with higher coupons

requiring a larger initial outlay, but subsequently generating

higher flow payments. Investor demand or different coupons,

which reflects their prepayment and interest rate projections,

ultimately affects originators best-execution strategies and

thus the point-rate grid offered to borrowers.

3. M OPUC

Our goal in this section is to derive an empirical measure

o average OPUCs (equation 4) or thirty-year fixed-rate

mortgages or the period 1994 to 2012. o do so, we need to

make a number o assumptions.

First, rather than valuing each possible loan note rate, we

value a hypothetical mortgage having a note rate equal to the

survey rate rom Freddie Macs Primary Mortgage Market

Survey, at weekly requency. We also use the weekly timeseries o average points paid rom the same survey.

Second, rather than accounting sepa-

rately or LLPAs and the flow g-ee, we use an effective g-ee,

which assumes that LLPAs are paid over the lie o the loan,

as reported in Fannie Maes Securities and Exchange Com-

mission Form10-Q filings. Te average size o the effective

g-ee is shown in Chart 3. In our calculations, we incorporate

anticipated changes in g-ees. In particular, the 10-basis-point

increases that came into effect on April 1, 2012, and Decem-

ber 1, 2012, are assumed in our calculations to apply to loans

originated January 1 and September 1, respectively, which is

right afer the increases were announced.Tird, as explained above, we need to value the servicing

income flow. Te coupon swap method has the advantage o

being based on current market prices that reflect changes in

the duration o the cash flows. But, as mentioned earlier, the

coupon swap may also reflect differences in assumed loan

characteristics across coupons; thereore, it may be a poor

proxy or the value o an interest strip rom a new loan.

o circumvent this issue, and also or the sake o

simplicity, our baseline calculations use fixed multiples o

5xor base servicing, 4xor excess servicing, and 7xor

buy-downs.22Tese are commonly assumed values in

industry publications. Later, we explore the sensitivity o

OPUCs to alternative assumptions.

Finally, we do a best-execution calculation, considering

three different BAcoupons (using back-month prices)

into which the mortgage could potentially be pooled.23Te

highest coupon is set such that it requires the originator to

buy down some or all o theg-feeup ront, while instead,or the other two possible coupon options, the originator

retains positive excess ser vicing because the loans interest

payment is more than sufficient to cover theg-feeand base

servicing.24Te best execution among the three options

determines our OPUC value or the week in question.

Beore turning to the weekly OPUC time series, we report

in able 3 a detailed OPUC calculation on a given day. We

can iner, rom the bottom o the table, that the mid-coupon

execution is optimal in this example.

22 We assume the buy-up multiple to be smaller than 4x, such that, in our

calculations, buy-ups are never used.

23 Te use o back- rather than ront-month BA price contracts reflects the

originators desire to hedge price movements during the lock-in period, as

discussed in more detail in section 4.

24 Depending on the mortgage rate, pooling into the highest candidate

coupon may not actually be a possibilityas explained, the mortgage rate

needs to exceed the coupon rate by at least 25 basis points.

15

20

25

30

35

40

45

50

55

12100806042002

Chart 3

Average Effective Guarantee Fee

Basis points

Source: Fannie Mae SEC Forms 10-K and 10-Q, various issuesthrough 2012:Q4.


10/23

T R G

3.1 Results

Te weekly OPUC series over the period 1994 to 2012 is

shown in Chart 4. Te series averaged about $1.50 between

1994 and 2001, then temporarily increased to the

$2.00-$3.00 range over 2002-03, beore declining again

and remaining below $2.00 or most o the period 2005-08.

Te OPUC measure jumped dramatically to more than

$3.50 in early 2009 and then again in mid-2010. Most notably,

however, it increased urther over 2012, and reached highs

o more than $5 per $100 loan in the second hal o the year,

beore declining again toward the end o 2012.

As shown in the back-o-the-envelope calculation in

Chart 2, the higher valuation o loans in the MBS market isthe main driver o the increase in OPUCs toward the end

o our sample period. Relative to that figure, the increase

in OPUCs over 2009-12 in Chart 4 is less dramatic; this is

because the earlier calculation implicitly valued servicing

through coupon swaps, which were very low in early 2009

but relatively high since 2010. In contrast, in Chart 4 we have

0

1

2

3

4

5

6

1210080604020098961994


Sources: JPMorgan Chase; Freddie Mac; Fannie Mae; authors calculations.

Chart 4

Originator Profits and Unmeasured Costs,1994-2012

Eight-weekrolling window

Weekly

Example of OPUCs Best-Execution Calculation

BA Coupon (Percent) 3.5 4.0 4.5 (1)

Coupon-independent inputs (percent)

Mortgage rate 4.78 4.78 4.78 (2)

Points 0.7 0.7 0.7 (3)

Effective g-ee 0.261 0.261 0.261 (4)

Base servicing 0.25 0.25 0.25 (5)

Excess servicing 0.769 0.269 -0.231 (6)=(2)(1)(4)(5)

Coupon-specific inputs (dollars per par value)

BA price (back-month) 97.55 99.95 101.67 (7)

Value o base servicing 1.25 1.25 1.25 (10)=5(5)

Value o excess servicing 3.08 1.08 (11)=4(6)i (6)>0

G-ee buy-down -1.62 (12)=7(6)i (6).25

Source: Authors calculations.

Note: Calculation is or April 30, 2009. OPUCs are originator profits and unmeasured costs; BA is to-be-announced.


11/23

FRBNY E P R / F

assumed constant multiples.25As we discuss in more detail

below, servicing right valuations appear to have declined,

rather than increased, over the past ew years, supporting the

use o fixed multiples rather than coupon swaps.

When interpreting the OPUC series, it is important to keep

in mind a ew notes. First, the measure uses data on thirty-year

conventional fixed-rate mortgage loans only and thereore

bears no direct inormation on other common types o loans,such as fifeen-year fixed-rate mortgages, adjustable-rate

mortgages, Federal Housing Administration loans, or jumbos.

Second, since the measure uses survey rates/points and

average g-ees, our OPUC series is an average industry

measure rather than an originator-specific one. In addition,

rates and points may be subject to measurement error that

could distort the OPUC measure at high requency, although

this should not have much effect on low-requency trends.

Tird, the measure is a lower bound to the actual industry

OPUCs, as it uses BA prices to value loans, while originators

may have more profitable options available. Indeed, as

noted in section 2, about 10 percent o conorming loans

are held on balance sheet, implying that originators find it

more (or equally) profitable not to securitize these loans.In addition, a significant raction o agency loans is securitized

in specified MBS pools that trade at a premium, or pay-up,

to BAs. In act, the raction o mortgages sold into the

non-BA market appears to have increased substantially in

2012, relative to earlier years. able 4 shows an estimate o

pools that are being issued as specified (spec) pools, rather

than BA pools.26Over the first ten months o 2012, only

about 60 percent (value-weighted) o all pools were issued to

be traded in the BA market, while the rest were issued as

spec pools. Te increase in spec-pool issuance is due in part

to Making House Affordable (MHA) loans originated under

the Home Affordable Refinance Program (HARP), whichaccount or about 20 percent o all issuance and typically trade

25 Another difference is that we take changes in points paid by borrowers into

account, but this matters relatively little (the average amount o points paid by

borrowers was relatively stable, between 0.4 and 0.8 over the period 2006-12).

26 We do not know with certainty whether a pool is ultimately traded in the

BA market or as a specified pool; we simply assume that pools that strictly

adhere to certain specified pool criteria are also subsequently traded as such.

at significant pay-ups to BAs, owing to their lower expected

prepayment speeds. For example, over the second hal o 2012,

Fannie 3.5 and 4 MHA pools with LVs above 100 traded

on average about 1 1/2 and 3 1/2 points higher than

corresponding BAs. Low-loan-balance pools, the second

largest spec-pool type, received similarly high pay-ups.

3.2 OPUCs, the Primary-Secondary Spread,and Pass-Trough

In assessing the extent to which secondary-market

movements pass through to mortgage loan rates, most

commentators ocus on the primary-secondary spreadthe

difference between primary mortgage rates and the yield on

MBS securities implied by BA prices. As shown in Chart 1,

the spread reached record-high levels over the course o

2012, suggesting that declines in primary mortgage rates

did not keep pace with those on secondary rates. For

example, while the primary-secondary spread averaged

73 basis points in 2011, the corresponding number was

113 basis points in 2012.

While the primary-secondary spread is a closely tracked

series, it is an imperect measure o the pass-through between

secondary-market valuations and primary-market borrowing

costs or several reasons.

Issuance of Various GSE Thirty-Year Fixed-Rate PoolTypes, JanuaryOctober 2012

Pool ypeBalance

(Millions o Dollars)Loan

CountBalance

(Percent)Count

(Percent)

BA 379,763 1,347,516 59 46

MHAa 124,779 559,180 20 19

Loan balanceb 97,161 867,628 15 30

Other specifiedc 36,588 138,735 6 5

otal 638,292 2,913,059 100 100

Sources: Fannie Mae; Freddie Mac; 1010data; Amherst Securities.

Note: GSE is government-sponsored enterprise. BA is to-be-

announced. MHA is the Making Home Affordable program.

aIncludes pools that are 100 percent refi with 80105 LV.bIncludes pools that contain only loans with balances less than or equal to

$175,000.cIncludes 100 percent investor, NY, X, PR, low FICO pools, and mutt

pools (variety o specified loan types). Excludes GSE pool types that arejumbo, FH reinstated, co-op, FHA/VA, IO, relo, and assumable.

The higher valuation of loans in the

MBS market is the main driver of the

increase in OPUCs toward the end of

our sample period.


12/23

T R G

First, the yield on any MBS is not directly observable,

because the timing o cash flows depends on prepayments.

Tereore, the calculation o the yield is based on the MBS

price and cash flow projections rom a prepayment model,

which itsel uses as inputs projections o conditioning

variables (or example, interest rates and house prices). In

addition, or BA contracts, the projected cash flows and

the yield also depend on the characteristics o the assumedcheapest-to-deliver pool. Te resulting yield is thus subject

to errors due to model misspecification.

Second, the primary-secondary spread typically relies on

the theoretical construct o a current coupon MBS. he

current coupon is a hypothetical BA security that trades

at par and has a yield meant to be representative o those

on newly issued securities.27Historically, this par contract

has usually allen between two other actively traded BA

coupons; however, in recent times, even the lowest coupon

with nontrivial issuance has generally traded signiicantly

above par (Chart 5). As a result, the current coupon rate

is obtained as an extrapolation rom market prices, ratherthan a less error-prone interpolation between two traded

27 An alternative is to calculate the yield on a particular security, which

may trade at a pay-up to the cheapest-to-deliver security. However, such a

calculation is still subject to other model misspecification and would not be

representative o the broad array o newly issued securities.

points.28Importantly, the impact o potential prepayment

model misspeciication on yields is ampliied when the

security trades signiicantly above (or below) par because

the yield on the security depends on the timing o the

amortization o the bond premium.

A better way to think about pass-through is to look

directly at what happens with the money paid by an

investor in the secondary marketdoes it go to borrowers,originators, or the GSEs (either up ront, or through

equivalent low payments)? he purpose o the OPUC

measure is to track how many dollars (per $100 loan) get

absorbed by originators, either to cover costs other than

the g-ee, or as originator proits.29G-ees also contribute

to the overall cost o mortgage credit intermediation

increasing these ees means that less money goes to

borrowers (or equivalently, that they need to pay a

higher rate). So, ull pass-through o secondary-market

movements to borrowers would require OPUCs and g-ees

to remain constant (or, alternatively, a rise in g-ees would

need to be oset by a decrease in OPUCs).

In panel A o Chart 6, we conduct a counteractual

exercise in which we compute a hypothetical survey note

rate during 2012, assuming that either the OPUCs only

(dark blue line), or both the OPUCs and the g-ee (light

blue line), had stayed at their average levels in 2011:Q4.30

he comparison o the light blue line with the black line,

the actual realized mortgage rate, shows that had the cost

o mortgage intermediation stayed constant relative to

2011:Q4, mortgage rates during 2012 would at times have

been substantially lower, with a maximum gap between the

two rates o 55 basis points in early October 2012.Comparing the black line with the dark blue line (holding

only OPUCs fixed but letting g-ees increase), we note that

over most o 2012, much o the gap between the actual

and counteractual rate derives rom the rise in OPUCs.

28 Additionally, the current coupon is typically based on ront-month contract

prices, while a more accurate measure would use back-month contracts,

because loans that rate-lock today are typically packaged into BAs at least

two months orward.

29 It is important to keep in mind that changes in the secondary yield, even

i correctly measured, do not necessarily translate one-to-one into changes

in originator margins, which are determined by the BA prices o different

coupons (which in turn determine optimal execution), and also by pointspaid by the borrower. Te primary-secondary spread, even net o g-ees, is

thus at best an imprecise measure o originator margins and profitability.

30 Te effective g-ee in our calculation or 2011:Q4 is 28.8 basis points,

which then increases to 38.9 basis points or the period January-March 2012

(as the announced increase effective April 1, 2012, is assumed to a lready be

relevant or loans originated at that point), 40.3 basis points or the period

April-June 2012, 41.8 basis points or July and August, and then increases

by another 10 basis points, to 51.8 basis points, or the rest o 2012 as the

December 1 g-ee increase becomes relevant to pricing.

Source: eMBS; JPMorgan Chase.

Notes: TBA is to-be-announced. Sizable issuance means thatthe coupon accounts for at least 10 percent of total issuance inthat month.

C

Price of Lowest Fannie Mae TBA Thirty-Year

Coupon with Sizable Issuance

Monthly average price (in dollars)

92

94

96

98

100

102

104

106

1210080604022000


13/23

FRBNY E P R / F

Additionally, it is apparent that in times when rates are stable

or increasing, the counteractual rate with constant OPUCs

tends to be close to the actual rate, and most o the gap

between the black and the light blue lines comes rom the

higher g-ees (this is the case, or instance, toward the end

o the year). It is during times when rates all (secondary-

market prices increase) that actual rates do not all as much

as they would with constant OPUCs. As we discuss later, thisis consistent with originators having limited capacity, which

means they can keep rates relatively high and make extra

profits. Tat said, one should not necessarily interpret the

counteractual rate series as indicating where rates should

have been, as this would require a judgment regarding

the right level o OPUCs. Here, we took the average over

2011:Q4 as our baseline, but i instead we took a lower value,

such as the average OPUCs over all o 2011, the dark blue and

light blue lines would be significantly lower.

In panel B o Chart 6, we conduct a similar counteractual

rate analysis, but using the primary-secondary spread as the

measure o the cost o mortgage intermediation. Holding

this spread (measured as the Freddie Mac survey rate minus

the Bloomberg current coupon yield) constant, we again get

a hypothetical mortgage rate under ull pass-through. As

shown in panel B, while the overall pattern is similar to the

counteractual rate with constant OPUCs and g-ees in panel A,

the series in panel B is more volatile, with the gap between the

counteractual and actual rate spiking at 75 basis points in late

September 2012. Tis volatility o the counteractual rate and

the presence o such large spikes illustrate the imperect nature

o the primary-secondary spread as a pass-through measure.

4. P E R C P

Te rest o the article explores in more detail actors that may

have driven the observed increase in OPUCs over the period2008-12. On the cost side, we ocus on changes in pipeline

hedging costs, putback risk, and possible declines in the

valuation o mortgage servicing rights. We also briefly discuss

changes in loan production expenses. On the profit side, we

ocus on potential increases in originators pricing power due

to capacity constraints, industry concentration, or switching

costs or refinancers.

4.1 Costs

Loan Putbacks

Originators pay g-ees to the GSEs as an insurance premium;

in exchange, the GSEs pay the principal and interest o the

loan in ull to investors when the borrower is delinquent.

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

4.2

Fixed-rate mortgage (FRM)rate with constant OPUCs

FRM rate withconstant OPUCs

and constant g-fee

C

Counterfactual Paths of Mortgage Rates over 2012

ActualFRM rate

Percent

Panel A: Holding OPUCs and g-fees constant at 2011:Q4 averages

Panel B: Holding primary-secondary spread constantat 2011:Q4 average

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

4.2

Q4Q3Q2Q1

FRM rate with constantprimary-secondary spread

Sources: Bloomberg L.P.; Freddie Mac; authors calculations.

Note: OPUCs are originator profits and unmeasured costs.

ActualFRM rate

Over most of 2012, much of the gap

between the actual and counterfactual

rate derives from the rise in OPUCs.


14/23

T R G

However, mortgage originators or servicers are obligated to

repurchase nonperorming or deaulted loans under certain

conditions, or example, when the GSEs establish that the loan

did not meet their original underwriting or eligibility require-

ments, that is, i the loan representations and warranties are

flawed.31Te repurchase requests have increased rapidly since

the 2008 financial crisis and have been the source o disputes

between originators and GSEs. Te increased risk to origina-tors that the loan may ultimately be put back to them has been

cited as a source o higher costs and thus OPUCs.

How can we assess the magnitude o the contribution o

putback costs to OPUCs? o do so, one needs to imagine

a stress scenarionot a modal onewith a corresponding

deault rate, and then assume ractions o putback attempts

by the GSEs, putback success, and loss-given-deaults or

servicers/lenders orced to repurchase the delinquent loan.

o construct a ballpark estimate o the possible putback

cost on new loans, we start rom the experience o agency

loans originated during the period 2005-08. Based on a

random 20 percent sample o conventional first-lien fixed-rate

loans originated during that period in the servicing data set

o LPS Applied Analytics, we find that about 16.5 percent oGSE-securitized mortgages (value-weighted) have become

sixty-or-more days delinquent at least once, and 11.5 percent

o them have ended in oreclosure.32Importantly, these

vintages include a substantial population o borrowers with

relatively low FICO scores, undocumented income or assets,

or a combination o these actors. For instance, the median

FICO score was around 735, while the 25th percentile

was at 690. In 2012, however, the corresponding values on

non-HARP loans were around 770 and 735, respectively.33

31 It is also possible that originators need to repurchase incorrectly

underwritten loans prior to a loan becoming delinquent. However, the

repurchase o nondelinquent loans is likely less costly to originators. Te

rest o this section thereore ocuses on repurchases o delinquent loans.

32 Tese statistics are as o November 2012.

33 Origination LVs have not changed as dramatically: in 2012, approximately

16 percent o non-HARP loans had an LV at origination above 80; this is only

slightly lower than during the period 2005-08. However, the raction o loans

with second liens was likely higher during the boom period. Also, in 2012 there

are no non-HARP Freddie Mac loans with incomplete documentation (this is

not disclosed in the Fannie Mae data, but is likely similar).

o account or the tighter underwriting standards on new

loans, we ocus on the perormance o GSE-securitized loans

rom the 2005-08 vintages with origination FICO o at least

720 and ull documentation. Among those, only about

8.8 percent have become sixty-or-more days delinquent, and

5.5 percent have ended in oreclosure. Tus, because o todays

more stringent underwriting guidelines or agency loans, our

expectation in a stress scenario would be or delinquencies,and hence potential putbacks, to be roughly hal as large,

relative to those experienced by the 2005-08 vintages. Further-

more, we would expect the requency o putback attempts to

be roughly hal as large or loans with ull documentation as

or the overall population o delinquent loans.

We obtain an estimate o the raction o loans that the

GSEs could attempt to orce the lender to repurchase rom

Fannie Maes 2012:Q3 Form 10-Q, which states (on page 72)

that as o 2012:Q3, about 3 percent o loans rom the 2005-08

vintages have been subject to repurchase requests (compared

with only 0.25 percent o loans originated afer 2008). Tus,

given that repurchase requests are issued primarily conditional

on a delinquency, we would anticipate repurchase requests

in a stress scenario to be about one-quarter (0.5 delinquency

rate0.5 putback rate) as high as those recorded on the

2005-08 vintage, or about 0.75 percent.34

Based on repurchase disclosure data collected rom the

GSEs,35it appears that about 50 percent o requests ultimately

lead to buybacks o the loan. Furthermore, i we assume a

50 percent loss-given-deault (which seems on the high side),

this would generate an expected loss to the lender/servicer o:

0.75 percent0.50.5 =19 basis points

Tis estimate, which we think o as being conservative

(given the unlikely repetition at this point o large house

price declines experienced by the 2005-08 vintages), would

imply a putback cost o 19 cents per $100 loan. Tis cost is

modest relative to the widening in OPUCs experienced over

the period 2008-12.36Tat said, perhaps the true cost o

putback risk comes rom originators trying to avoid putbacks

in the first place by spending significantly more resources

on underwriting new loans or on deending against putback

34 Without the assumption that ull-documentation loans are less likely to

be put back, the expected putback rate would be 1.5 percent, resulting in an

expected loss o 37.5 basis points.

35 Source: Inside Mortgage Finance.

36 Furthermore, the FHFA introduced a new representation and warrant

ramework or loans delivered to the GSEs afer January 2013 that relieves

lenders o repurchase exposure under certain conditions (or example, i the

loan was current or three years). Tis policy change should urther reduce

the expected putback cost going orward.

The increased risk to originators that the

loan may ultimately be put back to them

has been cited as a source of higher

costs and thus OPUCs.


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FRBNY E P R / F

claims. Furthermore, the remaining risk on older vintages is

larger than on new loans, and many active lenders are also

still subject to lawsuits on nonagency loans made during the

boom. It is unclear, however, why these claims on vintage

loans should affect the cost o new originations.

Mortgage Servicing Rights Values

Te baseline OPUC calculation assumes constant servicing

multiples throughout the sample o 5xor base servicing

and 4xor excess servicing flows. While these are commonly

assumed levels, according to market reports, mortgage

servicing right (MSR) valuations have declined over the past

ew years. In this section, we study the sensitivity o OPUCs

to alternative multiple assumptions.

We obtain a time series o normal (or base) servicing

multiples or production agency MBS coupons rom the

company Mortgage Industry Advisory Corporation (MIAC).37

Tese multiples declined rom about 5xin early 2008 to about

3.25xin November 2012.38o evaluate the impact on OPUCs,

we repeat our earlier calculation using the MIAC base multi-

ples.39Te results are shown in Chart 7. Comparing the black

(baseline) and dark blue (MIAC) lines, we see that the lower

multiple values reduce OPUCs by about sixty cents at the end

o 2012, a somewhat significant impact.

Some commentators have attributed the decline in

multiples to a new regulatory treatment o MSRs under the

2010 Basel III accord. While the three U.S. ederal banking

regulatory agencies released notices o proposed rulemaking

to implement the accord on June 12, 2012, the introductiono the new rules, originally set or January 2013, has been

postponed. Under the June 2012 proposal, concentrated

MSR investment will be penalized and will generally receive

a higher risk weighting.40Te long phase-in period or

37 Tese multiples come rom MIACs Generic Servicing Assets portolio

and are based on transaction values o brokered bulk MSR deals, surveys o

market participants, and a pricing model.

38 Key drivers o servicing right valuations are expected mortgage

prepaymentslower interest rates mean a higher likelihood that the servicing

flow will stop due to an early principal paymentand, in the case o base

servicing, varying operating costs in servicing the loan, or example, when

loans become delinquent. Another important component is the magnitude othe float interest income earned, or instance, on escrow accounts.

39 We assume a 20 percent discount or excess servicing and keep the g-ee

buy-down multiple unchanged at 7x. Also, as our MIAC series ends in

November 2012, we assume that the multiple in December is identical to

that in November.

40 MSRs will be computed toward ier 1 equity only up to 10 percent o their

value, and risk-weighted at 250 percent, with the rest being deducted rom

ier 1 equity. Tis treatment is significantly more stringent than the status

quo that risk-weights the MSRs at 100 percent and limits MSRs to 50 percent

o ier 1 capital o banks (100 percent or savings and loans).

these rules makes it unclear how much the expected tighter

regulatory treatment is already affecting MSR multiples.

Nonetheless, in order to assess an upper-bound impact

on OPUCs, we consider here a more stressed scenario

than implied by the MIAC multiples. In this scenario, our

baseline multiples are halved starting (or simplicity) with

the disclosure by the Basel Committee o the capital rules in

July 2010.41Te resulting eight-week-rolling OPUC series isalso depicted in Chart 7. As shown in the chart, ollowing a

halving o the MSR multiples, the implied OPUC declines are

significant, but still not sufficient to explain the historically

high OPUC levels in 2012.

We conclude that lower multiples, while having a sizable

impact on OPUCs, can only partially offset their increase

over the past ew years.

41 In this alternative scenario, base servicing is now valued at 2.5x, while

excess servicing is valued at 2x. (Te GSE buy-down multiple is assumed to

stay at 7x.) Te optimal execution in this exercise again takes into account the

lower levels o the multiples.

1

2

3

4

5

20122011201020092008

Chart 7

Sensitivity of OPUCs to Alternative Assumptions

about Mortgage Servicing Right Multiples


Sources: JPMorgan Chase; Freddie Mac; Fannie Mae; MIAC; authorscalculations.

Notes: The data reflect an eight-week rolling window. MIAC is theMortgage Industry Advisory Corporation.

1/2multiples

MIACmultiples

Baselinemultiples


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T R G

Pipeline Hedging Costs

For loans that are securitized in MBS, the mortgage pipeline

is the channel through which an originators loan commit-

ment, or rate-lock, is ultimately delivered into a security or

terminated with a denial or withdrawal o the application. Te

originators commitment starts with a rate-lock that typically

ranges between thirty and ninety days. Tis time windowappears to have increased significantly in recent years. For

example, the time rom application to unding or refinancing

applications increased rom about thirty days in late 2008

to more than fify days in late 2012 (as shown graphically in

section 4.2 below).

Originators ace two sources o risk while the loan is in

the pipeline: changes in the prospective value o the loan due

to interest rate fluctuations and movements in the raction

o rate-locks that do not ultimately lead to loan originations,

reerred to as allouts.

Te first riskpotential changes in the value o the loan

due to interest rate movementscan be hedged by sellingBA contracts: at the time o the loan commitment, origina-

tors who are long a mortgage loan at the time o the rate-lock

can offset the position by selling the yet-to-be-originated

loan orward in the BA market. Te calculation in section 3

already takes into account these hedging costs: when comput-

ing the OPUC measure, we use the back-month BA contract

price that settles on average about orty-five days ollowing

the transaction. o the extent that originators may have been

able to sell into the ront-month BA market when the length

o the pipeline was shorter, our calculations may understate

OPUCs or earlier years by the price difference, or drop,

between the two contract prices. Yet, this drop is typically

only about 20 basis points in price space. We conclude that

the lengthening o the pipeline does not appear to have had a

significant economic impact on the cost o price hedging, and

thus the rise in OPUCs experienced over the period 2008-12.

Te second risk is due to movements in the allout rate.

As discussed in section 2, borrowers terminations may occur

involuntarily (i they do not ultimately qualiy or the loan or rate

offer) or voluntarily. Except or changes in lending standards and

house prices, fluctuations in involuntary terminations are largely

driven by idiosyncratic actors that are diversified or originators

with large-enough portolios. Movements in voluntary

terminations, on the other hand, are mostly due to primary rate

dynamics: ollowing the initial rate-lock, mortgage rates may

all, prompting borrowers to pursue a lower rate loan with either

the same or a different lender. Common ways to hedge this risk

are to dynamically delta-hedge the position using BAs, using

mortgage options or swap options, or a combination o these

(or other) strategies.42o illustrate, we now consider a hedging

example using at-the-money swaptions to gauge the magnitudeand time-series pattern o the interest rate hedging cost.

Based on market reports and data rom the Mortgage

Bankers Association (MBA), normal allout rates average

about 30 percent, and we assume that an originator hedges

as much using swaptions. Chart 8 shows the price premium

in basis points or swaptions on a five-year swap rate with

expirations o one and three months. Conditional on a

30 percent hedging strategy, the cost o protection, when

using a three-month expiration, would be about 0.3 x40 basis

points=12 basis points, or a 12 cent impact on OPUCs. Te

extension in the length o the pipeline, which may have led

originators to go rom one-month to three-month expiration,

also had a rather small impact on OPUCs.

42 Correspondent lenders, or small lenders that sell whole loans to the GSEs,

can manage the allout risk by entering into best-effort locks with the buyer

o the loan. Under this arrangement, the originator does not need to pay a fine

or not delivering a mortgage that does not close, unlike under mandatory

delivery. o compensate, the price offered by the buyer o the loan is lower.

Tus, in a sense, best-effort commitments allow (small) originators to

outsource the hedging o allout risk.

0

25

50

75

100

125150

175

200

225

12100806042003

Chart 8

Swaption Price Premia

Basis points

Source: JPMorgan Chase.

Three-month,five-year

One-month,five-year

Originators face two sources of risk while

the loan is in the pipeline: changes in

the prospective value of the loan due to

interest rate fluctuations and movements

in the fraction of rate-locks that do not

ultimately lead to loan originations,referred to as fallouts.


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FRBNY E P R / F

More generally and beyond our specific example, implied

volatility and option price premia have declined significantly

since the all o 2008, reflecting the lower rate volatility

environment. While we do not explicitly consider other, more

complex hedging strategies, the lower volatility environment has

likely also lowered the cost o these strategies. Tis is in contrast

with the rise in OPUCs over this period. In sum, changing

hedging costs does not appear to account or a significantportion o the rise in OPUCs, and at least the cost o hedging

allout risk may in act have declined during the period 2009-12.

Other Loan Production Expenses

A final possible cost-side explanation or the increase in

OPUCs is that other loan production expenses, including

costs related to the underwriting o loans and to finding

borrowers (sales commissions, advertising, and so on) have

increased substantially over the past ew years. While it

is difficult to obtain a variable loan cost series that can be

easily mapped into the OPUC measure, the MBA collects

in its Quarterly Mortgage Bankers Perormance Report

survey inormation on total loan production expenses that

include both fixed and variable costs, such as commissions,

compensation, occupancy and equipment, and other

production expenses and corporate allocations. With the

caveat that the sample o respondents is composed o small-

and medium-sized independent mortgage companies, the

data indicate a modest increase in loan production expenses

over the past ew years and a airly stable pattern o these

expenses. For example, total loan production expensesaveraged $4,717 per loan in 2008, and $5,163 per loan in

2012:Q3.43Tis modest increase appears unlikely to explain

the more than doubling in OPUCs over the period 2008-12.

4.2 Industry Dynamics and OriginatorsProfits

Te discussion in the previous subsection appears to indicate

that the higher OPUCs on regular agency-securitized loans

over the period 2008-12 were not likely driven exclusively, oreven mostly, by increases in costs. As a result, the rise in OPUCs

during this time could reflect an increase in profits. I so, what

are the potential driving orces behind such an increase?

43 Source: Mortgage Bankers Association, Press Release Performance Report,

various issues. Te numbers cited are gross expenses, not including any

revenue such as loan origination ees or other underwriting, processing, or

administrative ees.

Capacity Constraints

An ofen-made argument is that capacity constraints in the

mortgage origination business have been particularly tight in

recent years, and that these constraints become binding when

the application volume increases significantly, usually due to

a refinancing wave. As a result, originators do not lower rates

as much as they would without these constraints, in order to

curb the excess flow o applications.

Chart 9 provides some long-horizon evidence on the

potential importance o capacity constraints or profits, by

plotting our OPUC measure against the MBA application

index (including both purchase and refinancing applications).

Te chart shows that the two series correlate quite strongly:

Whenever the MBA application index increases, OPUCs tend

to increase, and vice-versa.44

Tis correlation suggests that capacity constraints play an

important role in generating the higher OPUCs. Tat said,

mortgage applications (and other measures o demand and

origination activity, such as MBS issuance) were at higher levels

in the past, without OPUCs being as high as they were in 2012.Chart 10 shows some more direct evidence on the potential

importance o capacity constraints, by depicting the number

o days it takes rom the initiation o a refinancing application

to the unding o the loan. Te chart is based on data rom the

44 Over the period 2004-08, the relationship between the two series appears

weaker than elsewhereOPUCs appear to be on a downward trend over

much o that time, even when applications increase.

C

Originator Profits and Unmeasured Costs (OPUCs)and MBA Application Index

Dollars per $100 loan Index level

1

2

3

4

5

0

500

1000

1500

2000

1210080604020098961994

OPUCsLeft scale

MBA market volumeindex (all applications)

Right scale

Sources: JPMorgan Chase; Freddie Mac; Fannie Mae; MortgageBankers Association (MBA); authors calculations.

Note: e lines reflect eight-week rolling window averages.


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T R G

Home Mortgage Disclosure Act (HMDA), which was available

only through 2011 at the time o this writing, and rom the

Ellie Mae Origination Insight Report, which is only available

since August 2011.45It shows that the median (HMDA) or

average (Ellie Mae) number o days it takes or an application

to be processed and unded has been substantially higher since

2009 than it was in prior years.46Te processing time moves

in response to the MBA application volume shown earlier; orinstance, it reached its maximum afer the refinancing wave o

early 2009 and increased rom less than orty days in mid-2011

to more than fify-five days by October 2012, as refinancing

accelerated over this period. However, to the extent that the

HMDA and Ellie Mae data are comparable, it does not appear

that it took substantially longer to originate a refinancing loan

in 2012 than it did in early 2009, making it difficult to explain

the ull rise in OPUCs through capacity constraints.47

A final interesting question is how rigid capacity

constraints may be. Current originators can add staff, but it

45 See www.elliemae.com/origination-insight-reports/

EMOriginationInsightReportDecember2012.pd.

46 Te average or HMDA would be higher than the median, but would show

similar patterns.

47 It is interesting to note that the time rom refinancing application to unding

was significantly lower in 2003, even though application volume was much

higher than it was over 2008-12. Tis is likely driven by tighter underwriting in

the recent period compared with during the 2003 refinancing boom.

takes time to train new hires. New originators can enter the

market, but entry requires ederal and/or state licensing and

approval rom Fannie Mae, Freddie Mac, and Ginnie Mae to

ully participate in the origination process. o the extent that

training may take longer than in the past, or that approval

delays or new entrants are longer (as anecdotally reported),

the speed o capacity expansion may have declined compared

with earlier episodes.48Another potentially important actoris that the share o third-party originations (by brokers or

correspondent lenders) has decreased significantly in recent

years (as discussed in ootnote 5). Tird-party originators

may, in the past, have acted as a rapid way to adjust capacity,

especially during refinancing waves. In sum, while capacity

constraints likely contributed to the rise in OPUCs in recent

years, it is unlikely that they were the only source o this rise.

Market Concentration

A second popular explanation or the higher profits in the

mortgage origination business is that the market is highly

concentrated. It is well known that the mortgage market in

the United States is dominated by a relatively small numbero large banks that originate the majority o loans. However,

as shown in Chart 11, a simple measure o market concentra-

tion given by the share o loans made by the largest five or ten

originators actually decreased over the period 2011-12, as a

number o the large players reduced their market share. Tus,

overall market concentration alone seems unlikely to explain

high profits in the mortgage business. Tis would make sense

rom a theoretical point o view: Tere is no particular reason

why a concentrated market (but with a large number o ringe

players, and price competition) should incur large profits.

Recent work by Scharstein and Sunderam (2013) comes

to a different conclusion. Te authors argue that looking atnational market concentration may mask differential trends in

local market concentration, which matters i borrowers shop

locally or their mortgages. Using data rom 1994 to 2011, the

authors find that higher concentration at the county level is

48 Additionally, existing capacity may have been diverted to deending against

putbacks instead o new loan origination.

Overall market concentration alone

seems unlikely to explain high profits

in the mortgage business.

20

30

40

50

60

70

1211100908070605042003

Chart 10

Time from Refinancing Application to Funding

(by Month in Which a Loan Is Funded)

Number of days

Sources: HMDA (January 2003 to December 2011); Ellie Mae(August 2011 to December 2012).

Notes: HMDA is the Home Mortgage Disclosure Act. HMDA data

are restricted to first-lien mortgages for owner-occupants ofone-to-four-unit houses or condos.

Ellie Mae(average)

HMDA(median)


19/23

FRBNY E P R / F

correlated with a lower sensitivity o refinancing and mortgage

rates to MBS yields. It would be interesting to extend their

analysis to 2012 to see whether their findings can help explain

the increase in OPUCs in that year.

We next turn to an alternative explanation or why origi-

nators could make larger profits than in the past, namely that

they may enjoy more pricing power on some o their borrow-

ers or reasons unrelated to concentration.

HARP Refinance LoansA market segment where such pricing power may have

been particularly important is the high-LV segment,

which over the past years has been dominated by

reinancings through HARP, originally introduced in

March 2009. he introduction o revised HARP rules

in late 2011, oten reerred to as HARP 2.0, led to a

signiicant increase in HARP activity during 2012; the

FHFA estimates that in the second and third quarters o

2012, HARP reinancings accounted or about 26 percent

o total reinance volume.49HARP 2.0 provides signiicant

incentives or same-servicer reinancing (namely, relie

rom representations and warranties) that are not present

to the same extent or dierent-servicer reinancings.

Furthermore, even under identical representation and

warranty conditions, a new servicer may be less willing

to add high-LV borrowers to its servicing book, because

such borrowers have a higher likelihood o deli

1113fust.pdfthe rising gap between primary and secondary mortgage rates

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